A comprehensive understanding of the "culprit" behind the overnight U.S. Treasury bond crash - basis trading

Editor’s Note: Overnight, U.S. Treasury bonds experienced a significant plunge, with the yield on the 10-year Treasury bond soaring by 11 basis points to 4.3%. While U.S. stocks underwent a substantial correction, Treasury yields unusually rose sharply. One of the key reasons behind this abnormal phenomenon is basis trading.

So, what is basis trading? Why does basis trading lead to a crash? On April 1, Zhang Yu from Huachuang Securities published a research report titled "Hedge Fund Basis Trading Triggers Concerns Over Vulnerability in the U.S. Treasury Market," which explains in detail what basis trading is, how it affects the U.S. Treasury market, and its potential risks.

Core Views

1. As the supply of government bonds continues to grow, hedge fund basis positions are also increasing, and any external shock could trigger a more severe liquidity crisis. 2) The vulnerability of the U.S. Treasury market stems from three aspects: high-leverage basis trading by hedge funds, limited buffering capacity of broker-dealers, and increased vulnerability due to growing government bond supply. Among these, hedge funds' high-leverage basis trading of cash Treasury bonds and futures is the main source of market vulnerability. 3) Although traditional policy tools such as adjusting leverage ratios and increasing initial margins can improve the vulnerability of the U.S. Treasury market, there are still many limitations. Compared to traditional policy tools, Kashyap et al. (2025) suggest that the Federal Reserve should hedge interest rate risks by shorting futures while purchasing government bonds to maintain duration neutrality. This operation only provides liquidity support and does not change the monetary policy stance.

Report Summary

I. Hedge Fund Basis Trading Triggers Concerns Over Vulnerability in the U.S. Treasury Market

Experts from the Brookings Institution suggest that the Federal Reserve should consider establishing an emergency plan to close out high-leverage hedge fund trades in the event of a crisis in the $29 trillion U.S. Treasury market.

(A) What is Basis Trading in the U.S. Treasury Market?

Basis refers to the price difference between the spot market (the price of cash Treasury bonds) and the futures market (the price of Treasury futures). In the U.S. Treasury market, basis trading typically refers to an arbitrage strategy that exploits the price differences between cash Treasury bonds and Treasury futures. The goal of basis trading is to profit from buying the undervalued side (either cash or futures) and selling the overvalued side, profiting when the price difference converges.

(B) Who are the Main Participants in U.S. Treasury Basis Trading?

According to Kashyap et al. (2025), there are three main participants in U.S. Treasury basis trading: Asset Managers, Hedge Funds, and Dealers. The derivative demand from asset managers drives up the basis, attracting high-leverage hedge funds to arbitrage, while dealers, constrained by capital limitations, cannot fully absorb the liquidation shocks during stressful periods, leading to a deterioration of market functionality.

(C) Why Worry About Basis Trading Risks?

The vulnerability of the U.S. Treasury market stems from three aspects: high-leverage basis trading by hedge funds, limited buffering capacity of broker-dealers, and increased vulnerability due to growing government bond supply. Among these, hedge funds' high-leverage basis trading of cash Treasury bonds and futures is the main source of market vulnerability In addition, the continuous increase in government bond supply will prompt hedge funds to hold larger leveraged positions in government bond futures basis trading.

(4) How to cope with the risks of basis trading?

Limitations of traditional policy tools. Although traditional policy tools such as adjusting leverage and increasing initial margins can improve the vulnerabilities in the U.S. Treasury market, there are still many limitations, including the inability to address the fundamental vulnerabilities of basis trading, the inability to cope with capital shock-driven liquidations, the inability to eliminate the amplification effect of cyclical margin increases, and limited effectiveness in alleviating market liquidity crises.

Four advantages of hedged purchases. Compared to traditional policy tools, the Federal Reserve, while purchasing government bonds, hedges interest rate risk by shorting futures, maintaining overall duration neutrality. This operation only provides liquidity support without changing the monetary policy stance and has four advantages, including clearly distinguishing between market functions and monetary policy, not requiring a pre-set exit timetable, reducing interest rate risk exposure, and alleviating moral hazard.

Report Body

I. Concerns about Vulnerabilities in the U.S. Treasury Market Triggered by Hedge Fund Basis Trading

According to Bloomberg News, experts from the Brookings Institution suggest that the Federal Reserve should consider establishing an emergency plan to liquidate high-leverage hedge fund trades in the event of a crisis in the $29 trillion U.S. Treasury market. This week's report discusses this topic.

(1) What is basis trading in the U.S. Treasury market?

Basis refers to the price difference between the spot market (the price of government bonds) and the futures market (the price of government bond futures). In the U.S. Treasury market, basis trading typically refers to an arbitrage strategy that utilizes the price differences between government bond cash and government bond futures. Since the price of government bond futures reflects expectations for a specific government bond ("deliverable bond") in the future, while the spot price is the current actual trading price, there often exists a small but exploitable difference between the two.

The specific definition of basis is: Basis = Spot Price - Futures Price × Conversion Factor. The conversion factor is a tool used by futures contracts to standardize different deliverable government bonds, as government bond futures allow for the delivery of various eligible government bonds. The goal of basis trading is to profit by buying the undervalued side (cash or futures) and selling the overvalued side when the price difference converges.

(2) Who are the main participants in U.S. Treasury basis trading?

According to Kashyap et al. (2025), there are three main participants in U.S. Treasury basis trading: Asset Managers, Hedge Funds, and Dealers The demand for derivatives from asset managers has pushed up the basis, attracting high-leverage hedge funds to arbitrage, while dealers, constrained by capital limitations, are unable to fully absorb the liquidation shocks during periods of stress, leading to a deterioration of market functionality.

1. Asset Management Companies

As "real money" investors (such as pension funds, insurance companies, and bond funds), asset management companies are the only entities that actively bear interest rate risk (duration risk) in basis trading. Their core motivation is to achieve duration matching through a combination of cash securities and derivatives while optimizing the balance sheet.

Specifically, 1) holding cash securities, which means directly purchasing long-term government bonds and bearing interest rate volatility risk; 2) using derivatives, which means extending duration through futures or interest rate swaps to save balance sheet space for investing in corporate bonds and other high-yield assets. The net long demand for futures from asset managers pushes up futures prices, lowers implied yields on futures, leading to an expanded basis that attracts hedge funds and brokerage dealers to enter arbitrage.

2. Hedge Funds

Hedge funds arbitrage through cash-futures basis trading, that is, buying cash securities (Long Cash Treasuries) while shorting futures of the same duration (Short Futures) to earn basis income. Hedge funds finance their positions through the repo market with high leverage, requiring only a small amount of their own capital.

3. Brokerage Dealers

Brokerage dealers have a dual role, that is, market-making and arbitrage. Day trading market-making refers to providing liquidity for buying and selling cash securities to earn the bid-ask spread, while basis arbitrage refers to holding long cash securities and shorting futures, but they must fully hedge interest rate risk, with arbitrage income being the basis. When hedge funds liquidate their positions, dealers are forced to absorb cash security positions, crowding out market-making capital, leading to a simultaneous widening of the bid-ask spread and repo spread.

(3) Why Worry About Basis Trading Risks?

According to Kashyap et al. (2025), the vulnerabilities in the U.S. Treasury market stem from three aspects: high-leverage basis trading by hedge funds, limited buffering capacity of brokerage dealers, and increased vulnerability due to rising Treasury supply. Among these, hedge funds' high-leverage cash-futures basis trading is a major source of market vulnerability 1. High-Leverage Basis Trading by Hedge Funds

The core mechanism of hedge fund basis trading is that hedge funds finance high-leverage holdings of government bonds through repurchase agreements and hedge interest rate risk by shorting futures, forming a "cash bond - futures basis trade." Due to the low margin ratio, hedge funds only need a small amount of capital to hold large positions, relying on short-term financing rollovers.

However, high-leverage basis trading has obvious vulnerabilities: first, margin increases, meaning that during market volatility, futures exchanges may raise initial margins, forcing hedge funds to add collateral; second, disruptions in repurchase financing, where hedge funds face soaring financing costs or loan defaults when the intermediary capacity of dealers is limited.

Reviewing historical data from 2016 to 2024, the scale of hedge fund repurchase financing is highly negatively correlated with futures short positions. Additionally, in March 2020, we saw a sharp reduction in hedge fund short positions in U.S. Treasury futures. Specifically, during the brief interval from March 3 to 17, hedge fund short positions decreased by $62 billion, and hedge funds' repurchase financing securities also saw a similar decline.

2. Limited Buffering Capacity of Brokerage Dealers

Brokerage dealers maintain market functions through market-making (providing liquidity) and arbitrage (absorbing basis), but are constrained by regulatory restrictions (supplementary leverage ratios). Since brokerage dealers need to allocate limited capital among market-making, basis arbitrage, and repurchase intermediation, they are forced to shrink their business during periods of stress. For example, in March 2020, brokerage dealers absorbed $57 billion in cash bonds sold by hedge funds, but this led to a decrease in market-making capacity, causing the bid-ask spread for Treasury bonds to widen by 2.7 times.

3. Increased Vulnerability from Growing Treasury Supply

The continuous increase in Treasury supply will prompt hedge funds to hold larger leveraged positions in Treasury - futures basis trading. Asset managers need to extend duration through futures, raising arbitrage demand from hedge funds and dealers. According to empirical results from Kashyap et al. (2025), for every $10 billion increase in Treasury issuance, hedge fund futures short positions expand by $500 million

(4) How to cope with the risks of basis trading?

1. Limitations of traditional policy tools

According to Kashyap et al. (2025), although traditional policy tools such as adjusting leverage ratios and increasing initial margins can improve the vulnerabilities of the U.S. Treasury market, there are still many limitations. Specifically, 1) Adjusting leverage ratios can alleviate pressure on traders, but empirical evidence shows that its effectiveness is limited (Cochran et al., 2023), and it cannot address the fundamental vulnerabilities of basis trading. 2) Expanding the coverage of repurchase tools allows non-bank institutions (such as hedge funds) to directly use Federal Reserve repurchase tools to improve financing pressure, but it cannot address forced liquidation driven by capital shocks (such as margin increases or investor redemptions). 3) Setting minimum margin requirements can suppress leverage by increasing initial margins, but it cannot eliminate the amplifying effect of periodic margin increases, and regulatory rules need to be dynamically adjusted to respond to stress scenarios. 4) Central clearing can reduce the cost of basis trading through cross-margining, but it cannot prevent forced liquidations triggered by capital shocks, and its effect on alleviating market liquidity crises is limited.

2. Four advantages of hedged purchases

Compared to traditional policy tools, Kashyap et al. (2025) suggest that the Federal Reserve should hedge interest rate risks by shorting futures while purchasing Treasury bonds, maintaining overall duration neutrality. This operation only provides liquidity support and does not change the monetary policy stance. It has four major advantages: 1) Clearly distinguishes between market functions and monetary policy, avoiding the lessons learned from the confusion of policy objectives during the 2020 quantitative easing, preventing market misinterpretation of interest rate signals; 2) No need to preset an exit timetable, allowing for flexible liquidation based on market recovery; 3) Reduces exposure to interest rate risks, avoiding potential losses for the Federal Reserve from holding unhedged Treasury bonds; 4) Alleviates moral hazard, as hedging operations do not create a "Fed Put," reducing the incentive for hedge funds to take excessive risks.

Author of this article: Zhang Yu from Huachuang Securities, source: Yiyu Zhong, original title: "Concerns about the Vulnerability of the U.S. Treasury Market Triggered by Hedge Fund Basis Trading - Overseas Weekly Report No. 84," with some edits by Wall Street Insights Risk Warning and Disclaimer

The market has risks, and investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investment based on this is at one's own risk